Blog

The Problem

This week, I want to highlight a risk: when an unanticipated FinCEN Form 114 filing requirement might apply to a trust.

There is a weird situation where a foreign trust (as defined for income tax purposes) may be required to file FinCEN Form 114. (FinCEN Form 114 is how you tell the U.S. government about your foreign financial accounts).

It’s weird, but intentional.

Short Attention Span Summary

Does the trust look like a normal domestic trust but get taxed as a foreign trust? Watch out. You have a potential FinCEN Form 114 filing requirement.

Look Domestic, Taxed Foreign

There are good reasons to create trusts that look like domestic trusts but are taxed as foreign trusts.

Looks Domestic

In day-to-day administration of the trust, it looks like a normal trust that every bank sees 20 times a day. If court proceedings are necessary, a local judge can easily understand the trust document because it is created under local law.

In short, the trust looks like a domestic trust (because you have used a standard domestic trust document as a template, invoking local law), and operates as a domestic trust for business and legal purposes.

Taxed Foreign

The United States has a commendably stable legal system, safe currency, and robust economy. All of these make it attractive for nonresidents who wish to park capital in the United States.

Unfortunately, the United States has a robust and acquisitive tax system. If assets are parked in a trust, how can we avoid U.S. income tax on income generated on the trust assets?

One way to achieve this result is to have a “foreign” trust.

A foreign trust is treated, for U.S. income tax purposes, just like a nonresident alien human being who never sets foot in the United States. Briefly, there is no U.S. income tax on such a person, unless the assets generate U.S. source income.

When I Use This

I will often use trusts like this for holding U.S. real estate. For purposes of dealing with banks, title companies, and other day-to-day business affairs, it is useful to show people a seemingly normal trust document. They understand the document. It’s easy to get things accomplished.

But I might want to have the trust be taxed as a foreign trust, for reasons too diverse to discuss here. In that case, I will create an irrevocable trust that “looks domestic, but gets taxed foreign”.

How to be “Taxed Foreign”

The way to achieve “foreign trust” status is fairly simple. There are two toggles, either of which will cause a trust to be taxed as a “foreign trust” for U.S. income tax purposes:

A foreign court (rather than a domestic court) has jurisdiction over the trust’s administration;1 or

A foreign person has some (even if it is just a little) control over some substantial fiduciary powers of the trust.2

These are called the “court test” and the “control test”, respectively.

Court Test: We Can’t Use That as the Toggle

Since we want our trust to look and behave like a domestic trust, we have to leave court supervision of the trust with a U.S. court. The clause in the boilerplate near the end of the trust must specify one of the States of the Union (and the District of Columbia) as the governing law for the trust.3

Set up the trust in Delaware, for instance, and specify that Delaware law and Delaware courts should be used in all cases.

In short, we cannot make a domestic trust be taxed as a foreign trust by changing the governing law of the trust.

Control Test: That’s What We Use

But the second method for creating foreign status can be used.

An otherwise plain vanilla domestic trust is treated as a foreign trust for income tax purposes if some control over the trust is exercised by a foreign person. Give a foreign person some fiduciary powers over the trust’s administration, and it will be a foreign trust in the eyes of the IRS.

This is usually done by naming a foreign person as a Protector in the trust and giving the Protector special powers over the trust and its assets.

A Protector is basically someone who has superpowers to boss the Trustee around. You choose the superpowers you want the Protector to have: add or remove a beneficiary, force or withhold a distribution to a beneficiary, remove and replace the trustee, etc.

The result? The control test requires that all substantial powers over the trust be controlled by U.S. persons. You deliberately give some substantial powers to a foreign person, thereby failing the control test.

You just changed the trust from being a domestic trust (taxable on its worldwide income) to being a foreign trust (taxable only on its U.S. source income).

Oops. Silly me. 🙂

Example

Here’s an example of how it works:

Dad sets up an irrevocable trust in Delaware, under Delaware law, for his wife, children, and grandchildren. Everyone is a citizen and resident of Burkina Faso. There is an independent Delaware trust company as the trustee.

The Declaration of Trust names a Protector, who is a noncitizen of the United States and who lives in Monaco.

The trust passes the court test (if push comes to shove, the pushing and shoving happens in a Delaware courtroom), but fails the control test (the Protector has substantial powers over the trust’s administration, by design).

The trust is a foreign trust, therefore taxable just like a nonresident alien individual who never sets foot in the United States.

The trust puts all of its money into a bank account in Monaco, where it earns interest.

The interest income earned in Monaco is not taxable in the United States.

FinCen Form 114: When a Foreign Trust is a “U.S. Person”

FinCEN Form 114’s Basic Filing Requirement: “U.S. Persons” Only

We know we have a foreign trust for U.S. income tax purposes.

Let’s look at the trust’s potential obligation to file FinCEN Form 114 to report the existence of that bank account in Monaco.

“U.S. persons” are required to file FinCEN Form 114:

Each United States person having a financial interest in, or signature or other authority over, a bank, securities, or other financial account in a foreign country shall report such relationship to the Commissioner of Internal Revenue for each year in which such relationship exists and shall provide such information as shall be specified in a reporting form prescribed under 31 U.S.C. 5314 to be filed by such persons. The form prescribed under section 5314 is the Report of Foreign Bank and Financial Accounts (TD-F 90-22.1), or any successor form. * * * 4

“U.S. Person” Includes Trusts Formed Under U.S. Law

Trusts formed under U.S. law are “U.S. persons”:

For purposes of this section, the term “United States person” means . . . an entity, including but not limited to, a corporation, partnership, trust, or limited liability company created, organized, or formed under the laws of the United States, any State, the District of Columbia, the Territories and Insular Possessions of the United States[.]5

Note that while this is not identical to the “court test”, it is close enough to be functionally equivalent. And in other cases, different enough to cause consternation.

The court test uses the 50 States and the District of Columbia as the defining element for whether a trust is domestic or foreign. The FinCEN Form 114 regulations add the territories and possessions to that definition for defining where a trust is “organized or formed”.

The FinCEN Form 114 regulations talk about the location of organization. What if a trust organized in the Cayman Islands migrates its governing law and court of jurisdiction to Delaware? This change matters for the court test; does it matter for FinCEN Form 114? FinCEN Form 114 regulations seem to talk about the place of birth of a trust, but, like a human, a trust may live elsewhere after birth.

They Did This Deliberately

The government did this on purpose. With eyes wide open, the FinCEN definitions of “U.S. person” have been designed to include trusts that are “foreign trusts” for U.S. income tax purposes.

Commenters generally objected to the inclusion of trust in the definition. They argued that trusts should not have a separate filing obligation in light of the fact that a U.S. trustee would also have an obligation to file an FBAR with respect to the trust. Commenters also believed that the NPRM is unclear about whether a trust that is treated as wholly owned by another person under the Internal Revenue Code would be required to file an FBAR. Finally, commenters believed that the final rule should define trust with reference to the rules of the Internal Revenue Code, specifically section 7701(a)(30), rather than considering whether a trust has been “created, organized, or formed under the laws of the United States …”.

FinCEN acknowledges that in the case of trusts, a U.S. trustee must file the FBAR for the trust. However, FinCEN has decided to retain trust under the definition of United States person in the same manner that it has retained other entities such as corporations and limited liability companies.

FinCEN does not believe it appropriate to define trust under section 7701(a)(30) of the Internal Revenue Code because that definition might allow trusts formed under the law of a state to be excluded from the scope of FBAR obligations. For example, if a trust is formed under New York law and has one trustee who is a United States person and two trustees who are not United States persons, under section 7701(a)(30) the trust would not be considered a U.S. trust if all substantial trust decisions were not controlled by its U.S. trustee.

Why?

Pretty clear. Different heads of the Federal Hydra want different things.

The IRS (Title 26, United States Code) wants to collect tax.

FinCEN (Title 31, United States Code) wants to prevent Bad People™ from doing Bad Things™ with money. In other words, let’s not have the United States be used as a tax haven to hide or launder money, mkay?

The type of structure I described (classic Delaware irrevocable dynasty trust) has been deliberately put out of the IRS’s reach. But it is exactly the kind of structure that could be used to disguise the true owners of that bank account in Monaco.

Summary

Filing requirements require care to understand. I am not sure whether any mortal can fully comprehend all of the requirements that Federal law imposes. Be careful.

FinCEN Final Regulations for FBAR Reporting, 76 Fed. Reg. 10,234 (Feb. 24, 2011), Section III(B). Note that the relevant regulations underwent a renumbering frenzy. I am referring to the current scheme of numbering for the regulations. ↩